Entreprenuership (Chapter 6)

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Copyright © 2008 by Nelson, a division of Thomson Canada Limited

ENTREPRENEURSHIP

A PROCESS PERSPECTIVERobert A. BaronScott A. Shane

A. Rebecca Reuber

Slides Prepared by:

Sandra Malach, University of Calgary




6FINANCING NEW VENTURES

1




LEARNING OBJECTIVES1. Explain why it is difficult for entrepreneurs to raise

money from external investors.

2. Identify specific solutions to venture financeproblems created by uncertainty and informationasymmetry, and explain why these solutions work.

3. Explain why entrepreneurs typically raise very littlestart-up capital.

4. Create proforma financial statements and cash flowstatements and conduct breakeven analysis.




LEARNING OBJECTIVES5. Define debt and equity financing and explain how

they differ.

6. Describe the different sources of capital for newventures.

7. Describe the equity finance process from start tofinish.

8. Explain why equity financing in new ventures istypically staged.




LEARNING OBJECTIVES9. Describe how venture capitalists calculate the cost

of the capital that they provide to new ventures.

10. Explain why direct and indirect social ties areimportant to raising money from external investors.

11. Identify the behaviours and actions that successfulentrepreneurs engage in to encourage investors toback them, and explain why these behaviours andactions are effective.




INFORMATION ASYMMETRY

PROBLEMSEntrepreneurs have information abouttheir business that investors don’t have.

This creates three problems: Investors must make decisions on

limited information

Entrepreneurs can take advantage ofinvestors

Adverse selection




UNCERTAINTY PROBLEMS Investors must make judgments

based on little actual evidence

Entrepreneurs and investorsdisagree on value of newventure

Investors want collateral




SOLUTIONS TO VENTURE

FINANCE PROBLEMS Self financing

Contract provisions

Covenants

Convertible securities

Forfeiture and anti-dilution

Control rights

Vesting periods




SOLUTIONS TO VENTURE

FINANCE PROBLEMS Venture Capitalist Specialization

By industry

Be development stage

Geographically localized investing

Syndication




CAPITAL QUESTIONS How much money do I

need?

Where should I get thatmoney?

What type ofarrangements do I needto make to obtain thatcapital?




START-UP CAPITALHow much do you need?

Average Canadian business requiresunder $50,000 in startup capital.

Asset based start-ups require higherstart-up capital than hustle-based start-ups.




FINANCIAL ANALYSIS TOOLS List of startup costs and use of proceeds

Proforma financial statements

Cash flow statements

Breakeven analysis




STARTUP COSTS All costs incurred to get the business off

the ground

Capital costs for equipment & long-termassets

Working capital

Determine the capital you need Determine what you’ll do with the

capital once you get it




PROFORMA FINANCIAL

STATEMENTS Project the financial condition of the new

venture Estimate profit and loss (Income Statement) Cash Flow Statement Show financial structure of the business

(Balance Sheet) Allow investors to conduct ratio analysis

Performance Plushttp://sme.ic.gc.ca/epic/internet/inpp-pp.nsf/en/Home

http://sme.ic.gc.ca/epic/internet/inpp-pp.nsf/en/Home









INCOME STATEMENT Revenue – Expenses = Gross Income

Revenue derived from accurate market

analysis

Expenses derived from costs

Natural tendency to underestimate

Industries have similar relationships




BALANCE SHEET

Equity = Debit + Equity

Illustrates the financial structure of the

relationship




CIMITYM

Cash is more important

than your mother.




CASH FLOW

Amount of cash on hand at a givenpoint in time.

Cash vs. accrual based accounting

Cash inflows and outflows don’t alwaysoccur at the same time as revenue and

expenses are incurred.




INCOME TO CASH FLOW

Take your net profit and add backdepreciation

Subtract increases or add decreases inaccounts receivable

Subtract increases or add decreases ininventory

Add increased or subtract decreases inaccounts payable

Subtract increases or add increases innotes/loans payable




IMPROVE THE FLOW

Minimize accounts receivable

Reduce the raw material and finished

products inventory

Control your spending

Delay your accounts payable




BREAKEVEN ANALYSIS

Calculate the amount of sales you needto achieve to cover your costs

Determine the increase in sales volumeyou need to have in order to increasefixed costs

Total fixed costs________________

(unit sales price - unit variable costs)




DEBT VS. EQUITY

Debt —financial obligation to returncapital provided plus a scheduled

amount of interest Equity —The ownership of a company,

which takes the form of stock. It also

equals assets minus liabilities or networth.




FINANCING WITH EQUITY

New ventures tend to be financed byequity because:

New ventures have no way to makescheduled interest payments until theyhave positive cash flow

Debt financing at a fixed rateencourages people to take risky actionsto increase profitability




DEBT FINANCING

Debt guaranteed by theentrepreneur’s personal assets or

earning power Asset-based financing

Supplier credit




SOURCES OF CAPITAL

Savings

Friends and family

Business angels Venture capitalists

Corporations

Banks

Asset-based lenders

Factors Government

programs




SME FINANCING IN CANADA




CRITERIA FOR VENTURECAPITALISTS

Operate in high growth industry

Have proprietary advantage

Offer a product with a clear marketneed

Be run by experienced managementteam

Plan to go public




EQUITY FINANCE PROCESS

1. Referral of Entrepreneur to VentureCapitalist

2. Initial screening of ExecutiveSummary

3. Review Business Plan

4. Due Diligence

5. Negotiate the Terms




THE OPTIMAL TEAM

An excellent venture team with

Motivation

Passion

Honesty

Experience




THE OPTIMAL OPPORTUNITY

An excellent business opportunity with

Large market

Appropriate strategy

Compelling product description

Externally observable competitiveadvantage




DUE DILIGENCE

Investigation of

The business

The legal entity

The financial records




STAGING OF FINANCING

Staging of financing allows investors to

Minimize their risk

Gather more information over time

Manage the uncertainty of investing




RATE OF RETURN

The main factor that

determines the rate of

return for new

venture financing

The stage of

venture development




RATES OF RETURN &FINANCING ROUNDS




VENTURE CAPITALCOST OF CAPITAL




ENCOURAGING INVESTORS

Use impression managementtechniques

Create a good story Create a sense of urgency

Frame ideas to make them more appealing

Prepare a good business plan



Copyright © 2008 by Nelson a division of Thomson Canada Limited

SOCIAL CAPITAL

Investors are more likely to invest inentrepreneurs with whom they have a

direct or indirect business or social tie. Entrepreneur will be less likely to take

advantage of investor

Ability of investor to invoke sanctions Efficient way to gather information

Create positive attributions

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Entreprenuership (Chapter 6)

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